How Sustainable are Houston’s Pensions?

Elena FarahSenior Fellow for Public Financial SustainabilityThe Hobby Center for Public Policy, University of Houston

The poster child of the “Texas miracle” of growth and prosperity, Houston has been blessed with robust population and tax-base expansion, weathering the economic storm better than many other regions in the U.S. In fiscal 2012, for which the latest audited numbers are available, growth in property taxes accelerated and sales tax collections exceeded the high pre-2008 and 2009 crisis levels.

As a result of this healthy revenue stream and cost cutting measures implemented earlier, Houston was able to add $26 million to its undesignated fund balance reserves equaling approximately 8 percent of fiscal 2012 revenues, or $153 million. Unaudited financial projections for fiscal 2013, which ended in June, indicate another good revenue year, although it appears that the overall reserves position has declined somewhat.

The fifth most populous area in the nation, Houston MSA has added more than a million residents over the last 10 years, and this population influx is expected to continue aided by creation of jobs in the energy, transportation and distribution, as well as nationally and internationally renowned medical sectors, and the general quality of life.

But with this growth comes much responsibility, as Houston needs to expand its municipal and public service offering and continue to invest in its infrastructure network to accommodate additional businesses and residents who are not only tax payers, but also consumers of public services. Accomplishing this will take more than a miracle. It will take careful attention to structural pressures that exist in the budget, which, if left unaddressed, might take some of the steam out of an otherwise very impressive success story.

How Expensive are Local Pensions?

Does Houston have the necessary budgetary flexibility to grow its operational budgets while honoring its long-term statutory commitments like pension and health care obligations?

Fiscal 2012 debt service requirement to fund approximately $3 billion in outstanding general obligation bonds for capital improvements and $540 million in pension notes was just under $300 million, or 16.5 percent of fiscal 2012 revenues of $1.8 billion. Approximately one sixth of this amount, about $54, million went towards financing the costs of borrowing with pension notes to help bridge the unfunded pension liability in the municipal and police pensions funds. This is equal to 3 percent of total fiscal 2012 revenues.

The actuarially required pension contribution (ARC) to fully fund municipal, police and fire pensions constituted nearly $312 million in fiscal 2012, or 17.5 percent of total revenues. Thus, to finance its pension obligations – both bonded and “soft” – Houston should have allocated approximately 20 percent, or one fifth, of all its fiscal 2012 revenues.

This is a sizeable chunk of revenues competing against salaries, various city programs, on-going infrastructure investments, etc. The actual amount contributed to pensions was less than that at $225.7 million, or 12 percent of revenues. This means that Houston paid only slightly over 70 percent of the amount necessary to fund pensions in fiscal 2012, pushing the cost of underfunding forward to future budgetary cycles and/or administrations to deal with.

One of the reasons Houston has been routinely underfunding its police and municipal pensions over the last decade is because of unsustainable benefit enhancements passed in the early 2000s in the context of little policy transparency and public accountability.

The table below shows that until early 2000s Houston used to fully fund the required ARC for the municipal pension system (HMEPS) out of its annual budgets. After the 2001 benefit enhancement, Houston has been falling short on its required contributions because it is simply unable to pay the amount required in full:

Required and Actual ARC for Houston Municipal Employee Fund as % of Payroll

Source: (HMEPS Actuarial Valuation Report for the year beginning July 1, 2011)

The ARC to fund HMEPS pension requirement is projected to further increase to 30 percent of payroll by fiscal 2018. In other words, at that time one fourth (25 percent) of all municipal personnel costs are projected to go to fund pensions, with the lion share of those slanted to amortize the costs of legacy pensions.

In fiscal 2012 the unfunded liability for all three funds equaled $2.6 billion, or 143 percent of total City revenues.

To sum up, amounts Houston owes for pensions are far from trivial. And this is without taking into consideration employee healthcare obligations, which represented a separate $2 billion in fiscal 2012 and would have been enough to fully consume all revenues by themselves. These obligations are zero percent funded.

Can Unfunded Pension Liabilities be Resolved?

Addressing this problem of unfunded pension liability is likely to run against several challenges.

First, short-term electoral horizons of the Mayor and City Council members discourage local politicians from spending their valuable political capital to address unpopular social reform issues like pensions. Three two-year terms and inability to run for local office again represent too short of a time-horizon for most politicians, since political costs of attempting to reform public pensions are immediate and often painful, while benefits from reform accrue over the long-run.

Quite the opposite, politicians like to take immediate credit for enhancing public benefits, while their cost of funding may be successfully pushed forward towards future administrations. As a result, policy makers are most of the time not held politically accountable for running up pension bills.

Alleviating this term-limit obstacle might be made possible either by increasing term-limits to two four-year terms, or alternatively by shifting employee compensation towards increasing salaries funded out of current budgets and away from pensions due many years from now.

However, Houston is unlikely to accomplish any benefit reform without state involvement, since the City shares control over its local pensions with the state legislature. This represents the second challenge for local pension reform. To date Houston has largely failed to assemble a successful coalition at the state level to address either benefit levels or pensions governance structures.

Divided control over local pension issues is a recipe for a dysfunctional pension system, since state politics distorts local decision-making without the state’s having any financial obligation to pay local pension bills. Houston must be able to deal with its pension issues locally in order to restore its pension systems to solvency.

The third challenge is a lack of pension data transparency, which impedes the matching of employee benefit data to their respective working history to prevent pockets of inefficiency, such as benefit spiking. On several occasions Houston pension boards have withheld some important beneficiary data from either city officials or the city appointed actuary. Thus, Houston today is expected to pay its pension bills without complete understanding of their origin, which is incompatible with long-term sustainability.

Summary

As Houston has steadily evolved into a vibrant national and international economic hub it faces multiple opportunities as well as a number of challenges. Providing additional services to its expanding diverse community while honoring prior commitments requires a certain degree of budgetary flexibility that can barely be addressed by growing revenue sources alone.

Mandatory expenditures for past services are scheduled to consume an ever-increasing portion of the local budget in the near term. And it will take more than a miracle – but rather steady political will – to tackle local pension related indebtedness before it risks derailing Houston’s remarkable success.

[In an earlier version it was stated that HB 13 was not signed into law. In fact, it has been signed into law. We regret the error.]